Basics of Foreign Exchange Hedging: Top Five Things You Need to Know

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

When engaging in business across borders, companies typically deal in foreign currency. In some instances the foreign currency is received and must be sold for the native currency; in other instances payables are incurred in the foreign currency requiring the company to purchase the currency and deliver it to settle the obligation. Some companies also have foreign subsidiaries generating translation exposure to the parent. All of these foreign currency exposures create a risk of unfavorable movement in the rate at which the currency is exchanged. A currency hedge is an instrument that allows a company to protect against unfavorable movements in exchange rates. Below we review a few of the factors to consider when hedging a currency.

Volatility

Currency volatility is one of the biggest risks companies around the world face. In recent years, companies have increased their use of hedging strategies to protect against earnings volatility that can come about or occur as a result of large movements in the currency markets. A series of events has lead to this increase in hedging. It began with the sharp decline in emerging-market currencies during the financial crisis of 2008 and 2009. In that period, the USD and JPY strengthened as they were seen as safe havens. Now currency volatility is being driven by uncertainty over the health and stability of Europe, which has lead to significant gyrations in the Euro and emerging market currencies. For some companies, a 2 percent move in a currency can wipe out a bottom line, a move that can be exceeded in a single day.

Currency Cash Flows

Banking industry data suggests that U.S. companies hedged approximately 50 percent of their expected foreign cash flows in 2011. Companies typically hedge their foreign cash flows to reduce translation exposures to their base currency, thereby providing a greater degree of certainty for their base currency cash flows. In addition, hedging allows companies to protect against unfavorable movements relative to their budget rate, allowing for more stable earnings.

Hedge Instrument

The two most common instruments used for hedging against unfavorable currency movements are forwards and options. A foreign exchange forward is an agreement to buy or sell a currency at a specified exchange rate on a future date or during a specified period of time. Foreign exchange forwards are obligations in which both parties to the contract deliver a specified currency to the other party on a known date for a known amount of another currency. This makes a foreign exchange forward a “deliverable forward.”

Some countries, mostly in emerging markets, have instituted currency restrictions that prevent their currencies from being freely traded by offshore entities. Offshore companies doing business or engaged in trade with onshore entities may be required to deliver in USD or may be restricted from doing forward hedges for delivery in the local currency. Within these markets, hedging is still possible using a non-deliverable forward (NDF). In a NDF, the counterparts agree to an exchange rate at the time the transaction is executed, and then settle a net difference between the agreed NDF exchange rate and the prevailing market spot rate at maturity. At maturity the NDF rate will be compared to the current rate as set by the respective central bank (typically a weighted average of the day’s rate). If the currency strengthened, the company entering into the non-deliverable forward will receive a USD payment for the difference between the NDF rate and the fixing rate. If the currency weakened, the company entering into the NDF contract will make a USD payment to their NDF counterpart.

In addition to the NDF cash settlement, the underlying payment to the beneficiary for which the NDF exposure was created still would need to be made. If spot delivery the restricted currency in question is permitted, the company would purchase the foreign currency on the spot market to deliver to their beneficiary.

Any gain or loss from the non-deliverable forward contract will be offset by a gain or loss on the delivery of funds to the beneficiary. If spot delivery is not permitted, a USD equivalent of the foreign amount owed would be wired into the country and that would be converted locally. Once again, any gain or loss from the NDF would be offset by the amount of USD sent.

The NDF markets began trading actively in the 1990s. Below is a list of the currencies where non-deliverable forwards are traded actively traded. The list is not exhaustive.

Other less common hedge strategies that companies use for managing currency risk use a foreign exchange option or a combination of options. These strategies typically involve a hedging company either purchasing downside protection or setting a range in which their effective currency exchange rate will fall.

Hedged Percentage

The percentage of a company’s foreign currency exposure that is hedged will often be directly related to the predictability of its foreign currency cash flows. The greater the degree of predictability, the greater the percentage of exposure that is hedged. There is also a direct relationship between the degree to which foreign currency fluctuations can impact the bottom line and the percentage of exposures that are hedged. Typically low margin businesses hedge larger percentages of their exposures. Typically companies with predictable foreign cash flows hedge 50 percent or more of their exposures.

Method of Hedge Execution

Most companies that hedge recurring exposures use one of two methods, rolling hedges or layered hedges. Under a rolling hedge program, a company maintains a constant percentage of its cash flow exposures hedged for a predetermined period of time. As one hedge comes to maturity, the next period is hedged. Under a layered hedge program, a company hedges a percentage of its future exposures and then adds to future period hedges over time to increase the percentage of coverage in those future periods. Some companies prefer to do opportunistic hedging, in which hedges are executed when market conditions appear optimal. Historically, layered hedging provides the most stable currency exchange rates over time.

Ultimately, hedging offers a tool for mitigating currency exposure and providing a greater degree of certainty to margins and cash flows. It’s well worth the effort to set hedging strategies in place,if your company is engaged in cross border activities.

Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources. Opinions expressed are our opinions as of the date of this content only. The material is based upon information which we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied upon as such.

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

When engaging in business across borders, companies typically deal in foreign currency. In some instances the foreign currency is received and must be sold for the native currency; in other instances payables are incurred in the foreign currency requiring the company to purchase the currency and deliver it to settle the obligation. Some companies also have foreign subsidiaries generating translation exposure to the parent. All of these foreign currency exposures create a risk of unfavorable movement in the rate at which the currency is exchanged. A currency hedge is an instrument that allows a company to protect against unfavorable movements in exchange rates. Below we review a few of the factors to consider when hedging a currency.

Volatility Currency volatility is one of the biggest risks companies around the world face. In recent years, companies have increased their use of hedging strategies to protect against earnings volatility that can come about or occur as a result of...Read More